By Sydney Sekese, CFP® professional and member of the Financial Planning Institute
Do you want to be a millionaire? Most people probably do, but it is famously, not an easy pursuit. The growing wealth gap between the rich and the poor makes it seem impossible for most of us. I would like to suggest that wealth creation starts with small steps. A trivial thought that I came across reveals a 365 days’ savings plan as follows:
R5 every day = R1825 a year
R10 every day = R3650 a year
R30 every day = R10950 a year
R40 every day = R14600 a year
R45 every day = R16425 a year
R50 every day = R18250 a year
The above plan is a food for thought. It is a pity that banks do not yet allow inter account transfers to automate daily facilities of this nature. I am therefore challenging innovators out there to design a workable plan to accommodate daily saving plans.
On a pragmatic basis, compound interest is a buzzword that many financial advisors mention when clients are looking to get the most out of their savings. It was the legendary Albert Einstein who coined compound interest as the eighth wonder of the world. He continued to elaborate that “he who understands it earns it, he who doesn’t pays it”.
To understand it, let us provide a definition. According to Wikipedia, compound interest is the addition of interest to the principal sum of a loan or deposit. In other words, it is interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Let us illustrate with an example. Suppose you save R100 000 at a 10.5% rate for a fixed term deposit of 5 years. When you do not have interest paid out, it is effectively re-invested and earns interest again at the annual compounding rate. The payout at the expiry of the 5-year term would be R164 745. This scenario is one of the reasons why compound interest is a wonderful concept (the eighth wonder).
Compound interest is different from simple interest which is based on the principal amount of a loan or deposit only, while compound interest is based on the principal amount and the interest that accumulates on it in every period. Since simple interest is calculated only on the principal amount of a loan or deposit, it is easier to determine than compound interest.
In our example, if you decide to be paid annual interest instead of awaiting the 5-year term to expire, the payouts would be on a simple interest rate basis. The initial R100 000 invested would equate to a payout of only R152 500.
When people think of interest, they often think of debt. Think of it as the cycle of earning “interest on interest” which can cause wealth to rapidly snowball. Compound interest will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.
According to BusinessTech, to get the most out of compound interest, you should look at the following:
- Always be sure you are comparing the same rates on products – that is, the compound interest rates, and not the simple interest rates. If you are not sure, consult your advisor or the service provider(s)
- Also remember it is always better to leave your interest in the institution and let it accumulate for as long as possible to receive the greatest return (the compounding effect).
- You should always invest with a reputable service provider. Remember if the rate is too high, you may not be comparing apples with apples.
- If possible do not withdraw your interest. Reinvest your interest to get the most money back – to earn interest on interest.
- Always check if you will pay penalties if you withdraw your deposit early and/or what you can withdraw and when.
Final Thoughts
The power of compound interest shows how you can really put your money to work and watch it grow. When you earn interest on savings, that interest then earns interest on itself, and this amount is periodically compounded. At the Financial Planning Institute, we recommend the simple Money 123 principle which entails reducing debt, followed by setting up an emergency fund and saving (or investing) in that order. Compound interest is an “enabler” to meet your financial goals and create the desired wealth.
